Why airfares stay so low - while airlines struggle

Oil prices might be hovering just below record highs, but it's still almost as cheap to fly as it is to take the bus.

In fact, airfares are almost 20 percent lower than they were in 2000, even though jet fuel is more than twice as expensive.

That's expected to change this year, but not by much. Fares, which have been inching up in response to the spiraling oil prices, will probably continue to rise by only modest increments.

That's not good news for the ailing aviation industry, which, despite record cost-cutting and restructuring, is expected to rack up its sixth straight year of multibillion-dollar losses in 2006. But fliers - who are taking to the skies in record numbers - can thank something that could be called "the Southwest effect" for continued bargain-basement prices.

"Given how big Southwest is, they're a pricing leader, and they'll continue to keep [downward] pressure on airfares," says Helane Becker, an airline analyst at the Benchmark Co. in New York. "So there's a limit as to how high fares can go."

Southwest is now the nation's third-largest carrier, and it's growing at 10 percent a year. Its current ability to keep fares low is partly because it has 75 percent of its jet fuel hedged for this year. That has allowed it to pay about $1.20 a gallon, compared with the $2 a gallon most other carriers are paying.

So Southwest can remain profitable while other carriers - even Southwest's low-cost cohorts like JetBlue - are wallowing in jet-fueled red ink. Even though most airlines won't make enough money to cover their basic operating costs, they're hesitant to raise prices too much, for fear of losing even more customers to Southwest.

That means the so-called legacy carriers like United - which just emerged from three years in bankruptcy during which it shed $7 billion in annual costs - are facing another unprofitable year.

"They are going to limp along, but how long they can do this depends on the next economic downturn and the severity of it," says Kevin Mitchell, chairman of the Business Travel Coalition in Radnor, Pa. "If it's in the next couple of years, it could be difficult, because there's just nothing left to mortgage."

Yet some analysts believe this could at least be a turnaround year - if not a profitable one - for the legacy carriers. That's because as fuel prices push fares up - even if only a little for the leisure travelers - the legacy carriers will be able to increase business fares more. And because the legacy carriers have more extensive networks than their low-cost rivals, they can begin charging bigger premiums for people who want to go to out-of-the way places that aren't served by the low-cost carriers.

"The auto-part salesman in North Carolina that has to get to Erie, Pa., will pay anything to get there. There's huge growth in those markets, and Southwest can't get their paws on those passengers," says Michael Boyd, president of the Boyd Group in Evergreen, Colo.

While the legacy carriers can begin to cash in on their networks, Mr. Boyd notes, the low-cost carriers are more constrained in how much they can raise their fares because their success - and profits - are dependent on extremely price-sensitive travelers, many of whom would rather stay home on the couch than pay too much to see relatives. Add to this the fact that Southwest would also be losing money were it not hedged out until 2009, and Boyd believes that analysts will be talking about a very different "Southwest effect" come 2007.

"They're living on borrowed time, and they know that," says Boyd, referring to Southwest. "The Southwest model today doesn't work unless someone's paying 30 percent of your fuel. So I'd say, the Southwest effect [we're talking about now] is the reason that a year from now we'll be talking about the low-fare carriers as being in such deep trouble."